• Predatory Pricing Meets “Messynomics”

    Timothy Sandefur blogged today about the vanishing unlikelihood of a successful predatory pricing scheme:

    The theory goes like this: if one company cuts its prices really low, maybe even below cost (“loss leaders”) it’ll succeed in the market, and other businesses will fail. Then the first company will be a monopoly and jack the price up! The horrors! Thus the law forbids companies from trying to “harm competition” (i.e., succeed) by charging “unreasonably” low prices, and particularly by charging below cost. Loss leaders are illegal, for example, in California.

    Of course, a child can see the problem with the theory: the instant the “predator” does raise his prices, the other companies will open their doors again, charge the market rate, and the clever “predatory pricing” strategy will fail.

    In other news, Justin Fox observes (h/t to Ezra Klein for the link and for the term “messynomics”) that the unifying theme in the work of the latest crop of “Nobels” in Economics is that perfect-market models break down “with the injection of the tiniest bit of reality.”

    Now even skeptics acknowledge that predatory pricing can succeed (in theory) when firms that have been priced out of the market face sufficient barriers to reentry.  They just don’t accept in practice that such barriers ever occur.  Consequently, the presumption that markets are contestable has become effectively conclusive under the law.

    But a new paper by Berkeley’s Aaron Edlin argues that the theoretical foundations of skepticism about predatory pricing are weak even under the simplest assumptions, and that the evidence of its successful occurrence in the real world is substantial.  And once those simple assumptions are abandoned in favor of realistic ones about firms having asymmetric costs and information, he claims, predation winds up making perfect sense.

    You don’t need to be a Nobel laureate to suspect that even a modest nudge toward messiness would topple the Chicago School model of predatory pricing.  But if you did, you might be thinking along the same lines as many who now are.

    (Note to new readers: Since I was last a semi-regular contributor to this blog, before Aaron’s arrival, the content has become understandably much more focused on health care policy.  I have blogged on legal issues relating to that topic in the past, and will continue to do so.  When I write posts on other issues that are too serious for the weekend, I will tend to do so on Fridays.  The exception will be, as here, when my post builds on material from other blogs posted that same day.  I now return you to your regularly scheduled blogging.)

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    • Always important to remember that laws – including those against predatory pricing – did not arise in a vacuum. There weren’t a bunch of lawmakers sitting around saying, you know, some economists tell us that predatory pricing could be a problem, so we better pass a law against it.
      No, there were actual cases of industries being taken over via predatory pricing schemes. The NCR antitrust case is a famous example: )
      But the best example I can think of is: beer! For decades, most communities, especially ones with big German communities, had a local brewery. In my town – Springfield, IL – it was Reich, and I still remember their ads.
      But after the war, Anheuser-Busch would aggressively enter a town, underprice their beer and drive the local brewery out of business, then increase prices and dilute their product. (Strict, arcane liquor laws helped it in the quest.)
      A potential competitor would always have to consider the barriers to entry – cost of factory, licensing, etc. – and the fact that the predatory competitor still has the ability to undercut on price, as it can ride out the losses by being profitable elsewhere as well as having greater access to capital markets.
      Decades later, microbrews have re-established themselves as a high-end niche product, distinct from the low-cost giants. (And the large breweries are responding as they did fifty years ago – check the price of Budweiser American Ale vs., say, Sam Adams.)
      Lawmakers don’t legislate in response to theory. They act upon the world around them.

    • @RZ – Your example hits on a couple of points raised in the Edlin article. First, the baseline Chicago model assumes that fundamentals (like costs of production and capital) and information are symmetric. But this is often not the case in the real world, and it turns out that you don’t have to relax these assumptions much for predation to make sense. Second, even where the assumptions hold, predation and non-predation are both solutions to the model (subgame perfect equilibria in game theory speak), and the deciding factor in which one obtains is a potential entrant’s belief about whether an incumbent will engage in predation. So in your beer example, where a large company has lower costs and superior access to capital plus a reputation for commitment to punishing competitors, by Edlin’s argument, predation makes perfect sense.